MarketWatch Article on SEC Plans to Broaden Rules to Tackle Short Selling, July 30th 2008

SEC plans broader rules to tackle naked short selling

Industry group wants all publicly traded banks included in rules

By Alistair Barr, MarketWatch
Last update: 6:28 p.m. EDT July 30, 2008

SAN FRANCISCO (MarketWatch) -- The Securities and Exchange Commission is working on broader rules to tackle so-called naked short selling as the regulator tries to protect investors from what it calls "distort and short artists."
Late Tuesday, the SEC extended an emergency order mandating that all short sales of shares in 19 important financial-services firms be subject to a "pre-borrow" requirement. The order was set to expire on Monday but will now run until just before midnight on Aug. 12.
The order won't be extended after that, but the SEC said it will quickly move to come up with longer-term, broader rules to tackle naked shorting.
"The Commission will continue exploring other remedies for the broader marketplace," SEC Chairman Christopher Cox said in a statement late Tuesday.
The SEC, along with other regulators and government agencies, stepped in earlier this month to try to slow a steep slide in shares of large financial-services companies including Fannie Mae (FNM).

The SEC said late Tuesday that staff from the regulator will collect and analyze data on the impact of its emergency order. Once it expires, rule-making will follow.
Mixed impact
The impact on the shares of the companies covered by the order has been mixed. As of the end of trading on Wednesday, 10 stocks have fallen since the order took effect on July 21, while nine have climbed.
Fannie, Freddie and Lehman, among companies under the most pressure from the credit crunch, have declined 8.9%, 4.9% and 4.6%, respectively, in that period.
Other shares have performed worse, with those of Merrill Lynch (MER
CS) , up 22% and 15%, respectively.
To be sure, SEC Chairman Cox announced plans for the order almost a week before it kicked in. Some experts say the expectation that short selling of these stocks might become harder in the future may have triggered a strong rally in the wake of his comments.
Shares of Fannie, Freddie and Lehman jumped 31%, 19% and 32%, respectively, during the week Cox first announced the SEC's plans for an emergency order.
New rules
The SEC staff is considering several new rules, The Wall Street Journal reported on Wednesday.
One approach would be a price test limiting short selling during specific situations. A circuit breaker could be triggered when shares fall by a certain percentage, the newspaper reported.
John Heine, a spokesman for the SEC, declined to comment on specific rules that the regulator may be considering.
Banks want to be covered
The American Bankers Association said Wednesday that it was disappointed that the SEC didn't include all publicly traded banks when it extended the emergency order.
"ABA is concerned that those market participants that are actively involved in executing short selling strategies will focus their naked short selling strategies on those publicly traded banks and bank holding companies not covered by the order," Edward Yingling, president of the industry group, said in a statement.
"Without such action to include bank stocks in the ban, the potential exists that the Commission's action could backfire and disrupt an industry that is essential to the functioning of the economy," he said.
The ABA is hoping the SEC considers including all banks when it makes new rules that try to limit naked short selling.
Political will
"It is remarkable that the topic of banning naked short selling across the entire market is being discussed so actively," said Josh Galper, managing principal of consulting firm Vodia Group, which advises investors how to borrow securities. "Six months ago, the subject was as important as it is now but now there's the political will to make change."
The only thing that has changed substantially is the fact that stock markets are under more pressure than they were, said Charles Whitehead, a securities law expert at Boston University's School of Law.
"Putting in a rule that might cushion any downward pressure is a very politically astute thing to do in an election year," he said.
SHO me the stock
With the political wind at his back, Cox may also be able to close a "loop hole" in rules it came up with earlier this decade, Whitehead said.
In 2005, the SEC introduced regulation SHO to try to limit naked short selling.
In a typical short sale, traders sell borrowed shares, hoping to buy them back at a lower price and return them to the lender. The difference is kept as profit. What's different in naked shorting is that a trader shorts a stock without first making necessary arrangements to borrow shares. Naked shorting can distort markets because it artificially creates an extra supply of shares.
Reg SHO required brokers to "have reasonable grounds to believe" that they could locate stock to lend before allowing a short sale to proceed.
That has allowed some brokers to continue to lend stock that they may not be able to locate, Whitehead said.
The SEC's emergency order requires that brokers locate stock in the 19 companies before they lend and before short sales happen.
"Chairman Cox has the wind at his back and is able to point to the general market turmoil to help him overturn this loop hole in Reg SHO," Whitehead said. "This is a great opportunity for him to push through something that the staff has suggested in the past."
Still, groups representing the hedge fund industry have already cautioned against any quick rule-making in this area.
"We hope that any permanent changes be considered through a fair and open process in which the consequences of regulatory involvement in the setting of share prices can be better understood," said James Chanos, chairman of the Coaltion of Private Investment Cos. and head of short-selling hedge fund firm Kynikos Associates LP.
"Markets are best served when there is a level playing field between buyers and sellers, which in turn produces prices that have the greatest integrity," he said.
Alistair Barr is a reporter for MarketWatch in San Francisco.

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